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FINC3017 - IPM FINAL > TOPIC 3 - RISK AND RETURN > Flashcards

TOPIC 3 - RISK AND RETURN Flashcards

1
Q

Economy’s equilibrium level of real interest rates depends on

A

1) willingness of households to save

2) government fiscal and monetary policy

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2
Q

what reflects the willingness of households to save (as the driver of the economy’s equilibrium real interest rate)

A

reflected in the supply curve of funds and on the expected profitability of business investment in PPE and inventories as reflected in the demand curve for funds.

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3
Q

nominal rate of interest =

A

equilibrium real rate + expected rate of inflation.

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4
Q

in general can expected real rates of interest be observed?

A

No. can only observe nominal interest rates and from them we must infer expected real rates using inflation forecasts.

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5
Q

assets with guaranteed nominal interest rates are risky or safe

A

risky in real terms because the future inflation rate is uncertain

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6
Q

equilibrium expected rate of return on any security =

A

sum of the equilibrium real rate of interest, the expected rate of inflation and a security-specific premium,

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7
Q

Investors face a tradeoff btw

A

risk and expected return.

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8
Q

Historical data confirms what?

A

assets with low risk levels should provide lower returns on average than those with higher risk

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9
Q

historical rates of return over the last century in other countries suggests what about the US history of stock returns?

A

suggests the US history of stock returns isn’t an outlier compared to other countries

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10
Q

Historical returns on stock exhibit larger or smaller deviations from the mean than would be predicted from a normal distribution

A

larger, BUT discrepancies from the normal distribution tends to be minor and inconsistent across various measures of tail risk and have declined in recent years.

The lower partial standard deviation (LPSD), skew and kurtosis of the actual distribution quantify the deviation from normality.

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11
Q

What are the two widely used measures of tail risk?

A

1) value at risk (VaR)

2) expected shortfall (equivalent to conditional tail expectations)

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12
Q

What does Value at Risk (VaR) measure?

A

loss that will be exceeded with a specified probability (ie 1 or 5%)

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13
Q

What does the expected shortfall (ES) measure

A

expected rate of return conditional on the portfolio falling below a certain value, Thus, 1% ES is the expected value of the outcomes that lie in the bottom 1% of the distribution.

Conditional value at risk/ES is derived from the value at risk for a portfolio or investment.

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14
Q

Do investments in risky portfolios become safer in the long run?

A

NO. The longer a risky investment is held, the greater the risk!!!

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15
Q

The basis of the argument that stocks are safe in the long run is the fact that

A

the probability of an investment shortfall becomes smaller.

However, probability of shortfall is a poor measure of the safety of an investment because it ignores the magnitude of possible losses.

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16
Q

Whilst we have theories about relationship between risk and expected return that should prevail in rational capital markets, there is no theory about

A

the levels of risk we should find in the market place

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17
Q

given there’s no theory about the level of risk we should find in the market place, at best we can:

A

estimate from historical experience the level of risk that investors are likely to confront

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18
Q

given expected return nor risk are directly observable, what can we only observe?

A

realised rates of return (gains the investment made, offset by its losses and adjusted for inflation.)

–> provide noisy estimates of the expected returns and anticipated risk.

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19
Q

what’s the issue with relying historical rates of return?

A

No matter what the historical record says, we can’t guarantee it shows the worst an best that might be thrown in the future

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20
Q

holding period return =

A

total return earned on an investment during the time that it has been held

r(T) = [(Income generated) + (End value - initial value P(T))]/Initial value P(T)

P(T) = price paid today for a zero coupon bond with maturity date T, –> over the life of the bond the value of the investment grows by the multiple 100/P(T)

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21
Q

what does the holding period return formula show?

A

the longer you invest ur $ the higher returns you’ll get

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22
Q

How do we compare returns on investments with differing horizons? (ie, 0 coupon bond with longer maturity has lower PV and lower price, thus providing higher return).

A

effective annual rate

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23
Q

effective annual rate is defined as the % increase in funds per year –> what are we re-expressing?

A

we re-express each total return as a rate of return over a common period

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24
Q

EAR formula

A

= 1+ nominal rate/no. compounding periods

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25
Q

effective interest =

A

interest rate that’s adjusted for compounding over a given period

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26
Q

for a 1 year investment, the EAR is simply the:

A

total return on the bond, the % increase in the value of the investment which is (for investments <1 yr we compound the 1/2 yr return)

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27
Q

annual percentage rate (APR) vs effective annual rates (EAR)

A

EAR explicitly account for compound interest

APR just use simple interest and ignore compounding (use for short-term investments with holding periods <1 yr)

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28
Q

1 + EAR =

A

(1+ APR/n) ^n

it explicitly accounts for compound interest

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29
Q

APR =

A

n x [(1+ EAR)^1/n -1]

annualised using simple rather than compound interest

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30
Q

If you have an EAR and APR applied to the same 1 year investment at the same interest rate which will be higher?

A

the EAR, bc it increases each month by the multiple

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31
Q

What is a key difference btw the APR and EAR?

A

continuous compounding

EAR grows with the frequency of compounding

32
Q

1 + EAR = (1+ APR/n) ^n

as n gets learger, we start to approach what?

A

continuous compounding (CC) which is expressed as:

1 + EAR = e^rcc

(e being exponential)

33
Q

with the expression 1 + EAR = e^rcc for the EAR when n gets super large, how do we find rcc?

A

rcc = ln(1+EAR)

natural log function

34
Q

why do interest rates matter

A

1 of most important macroeconomic factors guiding investment analysis
- they directly determine expected returns in the fixed-income market

35
Q

are increases in interest rates good news or bad new for the stock market?

A

often bad news (can affect earnings & stock prices) –> means having good techniques to forecast interest rates valuable to an investor contemplating best asset allocation for portfolio

36
Q

4 factors that determine level of interest rates

A

1) supply of funds from savers (primarily households)
2) demand for funds from businesses to be used to finance investments in plant, equipment and inventories
3) gov’s net demand for funds as modified by actions of the central bank
4) expected rate of inflation

37
Q

nominal interest rate

A

interest rate before taking inflation into account

= growth rate of money

38
Q

real interest rate

A

growth rate of purchasing power
interest rate has been adjusted to remove effects of inflation to reflect real costs of funds to the borrower and the real yield to the lender/investor

39
Q

real interest rate formula

A

= (r_nom-i)/(1+i)

r_real approx = r_nom - i

where i = inflation

40
Q

nominal interest rate on a 1-yr CD is 8% and expect inflation as 5% over the coming year, then using the approximation formula: u expect the real rate of interest to be

A

r_real = 8%-5%

= 3%

41
Q

the approximation rule for approximating the real rate (ie, r_real = r_nom -1)

A

for small inflation rates and is perfectly exact for continuously compounded rates

42
Q

what 3 factors determine the real interest rate

A

1) supply
2) demand
3) gov actions

43
Q

when determining equilibrium real rate of interest, what does the demand curve show?

A

quantity of funds available for investment (horizontal axis)

44
Q

when determining equilibrium real rate of interest, what does the supply curve show?

A

real interest rate

45
Q

when we look at the equilibrium real rate of interest graph, th higher the price, the

A

lower the quantity of funds demanded by businesses at those higher interest rates (inverse true - the cheaper the funds the more businesses want to invest)

46
Q

where does the equilibrium real rate of interest occur?

A

where supply intersects demand

reflects point that corresponds to equilibrium amount of funds being lent in the economy and equilibrium rate of interest

47
Q

what can shift the supply and demand curves for the equilibrium real rate of interest

A

gov and central bank can shift to right or left thru fiscal and monetary policies

48
Q

whilst fundamental determinants of the real interest rate are the propensity of households to save and the expected profitability of investment in physical capital, the real rate can be affected as well by

A

government fiscal and monetary policies

49
Q

nominal rate of return on an asset is approx =

A

real rate + inflation

50
Q

bc investors are concerned with real returns (aka nom rate - inflation), we expect higher or lower nominal interest rates when inflation is higher

A

higher nominal interest rates

51
Q

fisher hypothesis

A

r_nom = r_real + E(i)

the nom interest rate apprx= real interest rate + expectation of price increases (inflation)

52
Q

what does fisher hypothesis argue

A

nom rate should increases 1for1 w expected inflation, implying that when real rates stable, changes in nominal rates ought to predict changes in inflation rates

53
Q

taxes and the real interest rate

A

tax liabilities based on nominal income and the tax rate determined by the investor’s tax bracket

54
Q

bc you pay tax even on earnings of interest (that’s merely compensation for inflation) your after-tax real return falls by

A

the tax rate X to the inflation rate

55
Q

fisher equation predicts

A

nominal rate of interest should track the inflation rate, leaving the real rate somewhat stable

56
Q

fisher equation appears to work better when

A

inflation more predictable and investors can more accurately gauge nominal interest rate they need to provide an acceptable real rate of return

57
Q

3 main sources of investment risk

A

o Macroeconomic fluctuations
o Changing fortunes of various industries
o Firm-specific unexpected developments

58
Q

when looking at the drivers of uncertainty and noting we need a metric to measure the return outcome what can we use?

A

holding period return =

(End share price - initial share price + cash dividend)/initial share price

59
Q

how else can HPR (holding period return) be stated:

A

HPR = dividend yield + rate of capital gains

60
Q

expected return and HPR =

A

sum of the probability of each scenario x the HPR of each scenario

61
Q

risk premium =

A

dif btw expected HPR and risk free rate

62
Q

if using arithmetic average to reference past performance, we treat each observation as

A

an equally likely return

63
Q

geometric (time-weighted average return)

A

(1+ g) ^n = terminal value

g = terminal value^1/n - 1

64
Q

when looking at historical data, is arithmetic or geometric rate of return greater?

A

the arithmetic average rate of return will always be greater than geometric average for riskier stocks

• Greater the variability in the year to year returns, the greater the difference (the more the arithmetic average exceeds the geometric average)

65
Q

what ratio can be used to evaluate performance of investment managers?

A

sharpe ratio (reward to volatility)

66
Q

sharpe ratio can only be estimated using

A

forward looking data

67
Q

sharpe ratio =

A

risk premium (rx - rf) / SD of excess returns (rx)

68
Q

Why do we look at the normal distribution?

A
  • 95.44% of returns fall within plus or minus 2 SDs within the mean
  • Return of portfolio comprising 2 or more risky assets, the return on the portfolio will also be normally distributed
69
Q

Skewness

A

standard measure of asymmetry in the probability distribution of returns

70
Q

kurtosis

A

about likelihood of extreme values on either side of the mean at the expense of a smaller likelihood of moderate deviations

measures degree of fat tails

71
Q

o Even if short term stock returns are normally distributed, it works out that long term stock returns

A

can’t be mathematically normally distributed, bc the way returns compound over time, (it’s not like taking an average of the returns and assuming it will be normally distributed),

if we’ve assumed over the shorter horizon they can be normally distributed they can’t be over the long time

72
Q

bc in the long-term returns aren’t normally distributed, what do we use instead of effectve annual returns?

A

continuously compounded rates, that grow per the timeline on the horizon

73
Q

The use of CVaR as opposed to just VaR tends to lead to

A

a more conservative approach in terms of risk exposure.

74
Q

The choice between VaR and CVaR/ES is not always clear, but volatile and engineered investments can

A

benefit from CVaR as a check to the assumptions imposed by VaR.

75
Q

Value at risk (VaR) is a statistic that measures and quantifies

A

the level of financial risk within a firm, portfolio or position over a specific time frame.

76
Q

VAR used to

A

determine the extent and occurrence ratio of potential losses in their institutional portfolios.

Investment banks commonly apply VaR modeling to firm-wide risk due to the potential for independent trading desks to unintentionally expose the firm to highly correlated assets.

FINC3017 - IPM FINAL (12 decks)

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